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Chris Gilchrist: Can advisers risk multi-asset investment ruin?

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People with modest pension pots do not want to buy annuities. So what should they buy? A diversified multi-asset fund, of course. Trouble is, there is a hole in this bucket.

Forget the stats saying that, over the 15-, 20- or 30-year term, a balanced portfolio (60/40 equity/bond) will do better than a low-risk one. Unless you know the client starting drawdown now is not among the 4 per cent (take any figure for this cohort with a large pinch of salt) that will be ruined by a poor sequence of returns, an adviser should not adopt the multi-asset fund as a default solution.

Why? Because your duty is to minimise the risk of ruin for your client. To quote Warren Buffett: “A small chance of distress or disgrace cannot be offset by a large chance of extra returns”.

As for the stats, the “risk of ruin” may appear low but ruin is like London buses: they bunch. All the clients going into decumulation in 2000 were hammered by the poor three years that followed. I have no better idea than you do about whether a two- to three-year bear market will start tomorrow or in three years’ time, yet that alone will make all the difference to people buying the multi-asset fund.

As for the history, how can you trust stats that cover 30 years or less when we have had a 30-year bull market in bonds? The downside risk in that 60/40 portfolio is higher today than at any time since 1980. Intuitively, I would say at least 25 per cent riskier. And forget 15 years: if it does go wrong, it will go wrong within five years and, if the client is heading for ruin, you should and will lose the case at the Financial Ombudsman Service.

In decumulation, what matters most is whether the client’s investments fall seriously in value in the first three years. If they do, and the client is withdrawing more than the natural income from the portfolio (as most do), there is a serious chance of ruin long before death. On the question of whether this will be any one client’s fate, there is no useful statistical answer: you face unknowable uncertainty, not probabilistically calculable risk. Remember Buffett: “Beware of geeks bearing formulas”.

For those highly dependent on the income from their investments, there are two robust decumulation solutions. One is to use an annuity to generate “fixed” income and a drawdown portfolio for discretionary income. The other is to use a “third way” product with guarantees.

Neither of these solutions offer the flexibility most advisers would normally want in an “income for life” solution, so I think many advisers will adopt “bucketing”. Putting two or three years’ “income” into a low-risk bucket and the rest into a long-term portfolio significantly reduces the risk of ruin. It also plays to clients’ (and advisers’) natural habit of mental accounting: this bucket for this, that bucket for that. You can even include a simple picture in your reports.

If you adopt a cash reserve strategy you can forget Henry’s woe and Liza’s litany of patches and instead join in the merry double-bucketeers’ refrain: “There’s an olé! in my bucket”.

Chris Gilchrist is director of Fiveways Financial Planning, a contributing editor to Taxbriefs Advantage and edits the IRS Report

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Comments

There are 7 comments at the moment, we would love to hear your opinion too.

  1. Peter Robertson 9th October 2015 at 1:10 pm

    Chris

    I think I have three problems with what you outline:

    1. Given the existence of state benefits (including the means tested ones) or an owner occupied house means the probability of “ruin” is 0%. The probability of exhausting your pension fund may be greater than zero but that’s a different issue.
    2.60/40 equity/bond is not “multi-asset”, you need more than 2 asset classes to do multi properly, ideally 4 or 5. Your client probably does have 4 – with cash and their own property added in, never mind state benefits.
    3. Even if I ignore 1&2, the cash bucket can’t work in the way you suggest. If it covers the next 2-3 years spending then each year I still need to sell some of the bonds or equities, as the market declines, to top up the cash bucket (if you are not topping up regularly then you are doing some kind of market timing, waiting for the market to recover before selling, as 2000-2003 shows, that can make matters worse). Adding cash has changed the asset allocation but not the need to sell in a falling market.

    I’d suggest the real answer is to talk to the client about what to do if things go awry, cutting spending, doing part time work, trading down. None are easy but I think all are more likely to work than making the portfolio more defensive by adding cash.

  2. I totally agree with the sentiments expressed by Chris in his piece. My only concern is that, as the cash bucket empties, it will require replenishment – and that must, presumably, come from the ‘growth’ bucket. So, to a degree, this seems to be just pushing the problem down the line by two or three years.

    As an additional complication, it then burdens the adviser with decisions about timing markets – a skill which I suggest most (if not all) of us lack to a, frankly, painful degree.

    I may say, in year two, ‘let’s not raid the growth bucket to top up the cash bucket because the market has not had a great year’, only to discover that the following year is even worse – and now the income bucket is looking dangerously empty …perhaps forcing a replenishment at an even worse time.

    For some time now, I have been pondering (and not reaching any meaningful conclusions about) a ‘cascading risk portfolio’ which is subdivided into four or five buckets of diminishing (or, at least, varying) levels of risk such that, on an ongoing basis, money is poured from the higher risk, higher growth funds to the lower levels – picture those old ‘coin cascade’ machines in the arcades of our youth (or maybe that was just me). The stumbling block (for me anyway) has been that the cascade would require established ‘trigger levels’ of relative asset values – and trying to think about how they might be set just gave me an enormous headache

  3. Anthony John Etkind 9th October 2015 at 3:53 pm

    As someone who, after 22 years as an IFA, is now retired and living off drawdown, I am acutely aware of the validity of both Chris’s arguments and Peter’s counter-arguments. Living off the “natural income” always seemed the best option to me, although many will simply have insufficient capital to enable them to do that; however a half-way house of living off the natural income plus say 1% of the capital is certainly an option that is unlikely to expose the drawdown fund too dramatically to the sequence risk.

    Putting 3 years’ income into cash or near-cash sounds all well and good, but the reality is that the income returns are so low that a higher income from the rest of the portfolio becomes mandatory, which itself carries a risk.

    We all know that annuity “income” is uncomfortably low, especially for indexed annuities. And the costs of guaranteed third way products are high – too high for them to make sense to investors needing to make sufficient income to live on.

    So why aren’t we honest with clients (and ourselves)? The conversation could go: “Mr Client, the only way we can guarantee that you will receive an income that will increase each year with inflation is to buy you an index-linked annuity; unfortunately you have not saved enough/your pension portfolio has not grown sufficiently to enable you to live comfortably on the index-linked income that your pension pot will buy. So either you have to spend less or you have to take one of a number of risks in the hope that the investment return you obtain will be sufficient to support you (and your spouse) for the rest of your lives. However there is a significant chance that the risks will not pay off and your pension pot will diminish significantly and could even be exhausted if you take out of it significantly more than the returns earned.” Thereafter have a discussion of all the options, with the suggestion of taking the natural income plus a small % of capital – and don’t forget that the annual reviews may sooner or later throw up the advice to take an annuity, especially if rates rise or the client becomes entitled to an impaired life annuity.

  4. No easy answers, although I approach it in a simplistic way, working out roughly how many years the capital would last with no growth, based on a prescribed income requirement. If that figure is well beyond life expectancy then the assets should outlive the client.

    Whilst it is a noble gesture to try to leave the capital intact for the next generation, clients must accept the fact that their assets may have to deplete to meet known and unknown costs, such as care fees. The bottom line is that if they have not saved enough for retirement, then no amount of financial engineering can alter the fact that something has to give.

    The question I often get is ” can I stop work now”, often years before Defined Benefits come into play, and it is very satisfying to be able to say “yes, but you will need my help to make the money last longer”

  5. No one ever mentions gold. Doesn’t pay the bills. Poor drawdown folk, poor pensioners, all doomed as the bubble bursts.

  6. Enjoy the crash this month by the way!!

  7. Peter, the multi-asset portfolio doesn’t significantly reduce the risk- historic drawdowns are similar to the 60/40 portfolio. Multi asset is just the asset managers’ latest marketing ploy. Of course people have other assets they might use if the investments run out – I was talking about financial ruin on their life savings. I need another 600 words to discuss bucket top-ups, but in a nutshell: multi-buckets (four or even 5) reduce risk further but create huge management issues; such techniques have only been used by advisers for clients with larger capital sums and will only be more generally useable if they can be automated. A simple rule like ‘top up the income bucket only in a year when the portfolio value has risen 5%’ would have worked in the past, except in the long bear market of the 1930s.
    Anthony, if you can survive on natural income plus 1% from capital you can afford to live for ever, so you don’t need to worry! (but is that net of all charges???)

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